Dollar Going Out With A Whimper, Not A Bang - So Far

Last year the US ran a $272 billion trade deficit with China, which means
we sent the Chinese that many extra dollars in return for the clothes, toys
and iPhones they sent us. This lopsided relationship has been in place for
a long time, allowing (or requiring) China to accumulate about $1.7 trillion
dollars of various kinds of US paper.

From China's perspective, this is a good deal in the short run but potentially
a bad one longer-term. And lately the world has been wondering what they would
do with all this low-yielding, rapidly-depreciating currency. The worst case
scenario had them reacting to US deficits and debt monetization by converting
their dollars into real assets at pretty much any price, sending the value
of the dollar through the floor and igniting a currency crisis or hyperinflation.

Optimists dismissed the above as unlikely, since traders would see the change
in strategy coming and front-run China by dumping dollars immediately, decimating
the value of China's remaining reserves. So the only option for China -- and
Japan, Saudi Arabia and other big trade surplus countries -- is to keep playing
the game by accumulating dollars in order to protect the value of their current
reserves.

But there's a lot of policy room between unrestrained accumulation and complete
abandonment of the dollar. A surplus country can, for instance, keep accepting
dollars but convert a growing share of them into other currencies or hard assets,
over time lessening the dollar's relative importance. This, it turns out, is
exactly what China has been doing:

Beijing--Fresh U.S. Treasury data suggest that China has lost its taste
for investing as much of its $3.2 trillion in foreign-exchange reserves in
U.S. dollars and may be increasing its holding of euro-denominated securities
during a time that a debt crisis has roiled European markets.

Economists have long warned that if China started to cut back its purchases
of U.S. securities, U.S. interest rates could climb, damaging the U.S. economy.
China's diversification of its vast reserves, however, hasn't caused disruption
so far, partly because of strong global demand for U.S. securities as a safe
haven during troubled times.

Overall, foreign demand for dollar securities has remained strong; foreign
holdings increased $1.8 trillion, or about 17%, to $12.52 trillion over 12
months to June, according to the Treasury data.

But the data, which provide one of the very few clues about how China invests
its reserves, suggest that the percentage of dollar holdings in China's foreign-exchange
reserves has fallen to a decade-low of 54% from 65% in 2010. Purchases of
U.S. securities equaled just 15% of the increase in China's foreign-exchange
reserves in the 12 months, down from 45% in 2010 and an average of 63% over
the past five years, according to calculations based on information published
by the U.S. Treasury and the Chinese government.

Some economists said China's move was well-timed. "It would be optimal for
China to adopt a contrarian strategy and pick times when the dollar is strong
to aggressively diversify the currency composition of its reserve portfolio
away from the dollar," said Eswar Prasad, a China scholar at the Brookings
Institution.

China won't say how it invests its foreign-exchange reserves, which have
grown rapidly over the past decade. Beijing has used its control over the
exchange rate as a key plank of its development strategy and has racked up
immense trade surpluses. That requires China's State Administration of Foreign
Exchange to invest the proceeds overseas. In the past, SAFE has hinted that
about two-thirds of its stash is held in U.S. securities, a percentage that
generally has been in line with annual data collected by the U.S. Treasury.

The new Treasury data suggest China has begun to rapidly diversify its portfolio
of currencies. "It clearly indicates China's intention not to put all eggs
in one basket," said Lu Feng, director of Peking University's China Macroeconomic
Research Center.

China has many reasons to try to reduce its exposure to the dollar. They
include very low yields paid by Treasuries and a vulnerability to U.S. decisions
on managing its debt that could lead to inflation that would erode the value
of those holdings. Last summer's political debate over raising the U.S. debt
ceiling sparked worries that the U.S. could default on some payments.

To arrive at the percentage of dollar holdings in China's reserves, U.S.
Treasury data on Chinese purchases of U.S. securities must be compared to
Beijing data on its foreign-exchange holdings. That calculation is complicated
by the impact of currency movements on the value of China's reserves. Even
so, it is clear that China is purchasing fewer dollar-based securities than
it had in the past.

Treasury data show that China's holdings of U.S securities edged up 7% up
to $1.73 trillion as of June 30, translating into an increase of $115 billion
from 12 months earlier. Over the same time, China's foreign-exchange holdings
increased by 30% to $3.2 trillion, an increase of $743 billion. Essentially,
the pace of China's purchases of U.S. securities didn't come close to matching
the pace of expansion of its foreign reserve pile, reducing the percentage
of dollar holdings in China's foreign exchange haul.

Nick Lardy, an expert on the Chinese economy at the Peterson Institute,
noted that a fall in China's holdings of debt issues by troubled mortgage
giants Fannie Mae and Freddie Mac accounted for most of the decline. Over
the period covered by the annual survey, China continued to add to its holdings
of U.S. Treasurys, he said.

Monthly data on China's holdings of U.S Treasurys has been seen as less
reliable than the annual survey. But the Treasury has now introduced a new
survey technique intended to improve the accuracy of the data. The latest
numbers show China's holdings of U.S Treasurys dropped to $1.15 trillion
in December, falling $156 billion since the period covered by the annual
survey. That suggests China's diversification away from dollars may have
continued in the second half of 2011.

As China has appeared to lose its dollar appetite between June 2010 and
2011, the greenback weakened 9.2% against a broad range of currencies according
to the Federal Reserve. It has since risen about 3%, as the euro crisis deepened
and the U.S. economy has shown signs of strengthening.

Where did the money not invested in dollars go? China's SAFE won't say.
Officials at the foreign-exchange agency didn't respond to questions faxed
to them on Thursday.

But China's leaders have made increasingly strong statements that they would
like to help the 17-nation euro zone deal with its troubles. In February,
Premier Wen Jiabao, speaking at the EU China summit, said "Europe is a
main investment destination for China to diversify its foreign-exchange reserves."

Klaus Regling, the chief executive of the European Financial Stability Facility--the
euro-zone's rescue fund for Greece and other financially troubled nations--was
in Beijing in October for talks with SAFE. Regular talks have continued since
then and EFSF documents show that Asia, apart from Japan--essentially China--accounted
for between 14% and 24% of purchases for three EFSF bond sales worth €13
billion in the first half of 2011, before Mr. Regling's trip to Beijing.

Stephen Green, China economist at Standard Chartered, said the majority
of China's increased investment in Europe has probably gone into core euro
zone countries like Germany that boast relatively low debt levels. Chinese
officials have privately made clear that they are wary of buying bonds directly
from Greece, Portugal and other troubled European nations.

With Europe's fiscal situation being even more precarious than that of the
U.S., a shift of reserves into euros brings its own risks.

Mr. Green, the Standard Chartered analyst was acerbic in describing China's
choice between investing in the U.S. and Europe: "At least if you diversify
into Europe, you are balancing your risks between two equally awful fiscal
messes."

Some Thoughts

Moving out of dollars and into euros, even via German bonds, is not, as the
analyst quoted above points out, an especially high-percentage bet. There are
two explanations here: 1) China doesn't understand Europe's dilemma, which
is that either the eurozone falls apart -- a bad thing for all European paper
-- or Germany takes the peripheral countries' debt onto its own balance sheet
via guarantees and direct aid, which is bad specifically for German paper.
Or 2) China grasps Europe's situation but is so desperate to get out of dollars
that it's willing to "diversify" into something just as bad.

But it's not just euro-bonds that China is accumulating. They've been buying
gold (only admitting it after the fact), and farmland and mines in Africa and
Latin America. So the quality of their portfolio is rising as it shifts towards
hard rather than financial assets.

As the article also notes, China's scaling back of its dollar holdings in
relative terms hasn't caused the dollar to tank because the rest of the world
is so troubled that money is flowing into dollars by default. This is probably
temporary. Either the rest of the world gets its act together and begins to
look safe again or the US is sucked into the maelstrom of a eurozone implosion
or Middle East war or whatever. Or our ongoing debt binge finally gets
the scrutiny it deserves and even in an unsafe world the US is discovered to
be fundamentally unsound.

So for surplus countries the dollar's recent exchange rate stability is a
great chance to sell into strength and accelerate their diversification programs.
Next year's numbers will probably show another big shift out of dollars.

Why does it matter what China or any other country does with dollars the US
has already created and spent? Because the foreign exchange markets are where
the dollar's value is determined, and the numbers are now huge. There are maybe
$3 trillion in the vaults of just a handful of countries, all of whom want
to protect their investment and none of whom trusts the US to do it for them.
If China is seen as easing itself out of dollars without adverse consequence,
then the other big dollar holders will be tempted to follow suit. The result:
a growing number of sellers, which will eventually send the dollar down at
an accelerating rate, which will cause the remaining dollar holders to panic
and head for the exits. Trillions of dollars being converted to hard assets
or euros and yen (or Mexican pesos or Brazilian real) all at once is a currency
crisis that the Fed won't be able to stop.

John Rubino is author of Clean Money: Picking Winners
in the Green Tech Boom (Wiley, December 2008), co-author, with GoldMoney's
James Turk, of The Collapse of the Dollar and How to Profit From It (Doubleday,
January 2008), and author of How to Profit from the Coming Real Estate
Bust (Rodale, 2003). After earning a Finance MBA from New York University,
he spent the 1980s on Wall Street, as a currency trader, equity analyst and
junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and
a frequent contributor to Individual Investor, Online Investor,
and Consumers Digest, among many other publications. He now writes
for CFA Magazine and edits DollarCollapse.com and GreenStockInvesting.com.